[copy also posted to LinkedIn]
Following up on an item I posted here last August. This is the second in what may turn out to be an intermittent series.
The other day I was engaged to write up a "qualified appraisal" on the assignment of a gift annuity to the issuing charity. A not at all uncommon transaction that should maybe be more common than it is.
This is a gift of a noncash capital asset,[a] subject to the 30 pct. limitation per section 170(b)(1)(B).
If the taxpayer acquired the annuity in exchange for appreciated property, her basis in that property would have been pro rated between the "gift" and "sale" components of the transaction. Over a term of years called the "expected return multiple," i.e., her table life expectancy at the time the annuity was set up, a portion of each payment represents a recovery of basis and a portion represents realization of gain, somewhat in the manner of an installment sale.
Yet another portion of each annuity payment is ordinary income. If the annuitant survives the "expected return multiple," she will have fully recovered her "investment" in the contract,[b] the basis and capital gain components, and the entire annuity payout going forward will be ordinary income.
Are you with me so far.
The present value of the unexpired annuity itself trends down as the annuitant ages, but it also fluctuates as the section 7520 rate moves up or down. In the particular case, just as the taxpayer was making the decision to assign the annuity to the issuing charity, the 7520 rate was rising rapidly.
The rate for April was already up to 2.2 pct., and we were looking at a solid 3.0 pct. coming up in May, the highest rate in three years. But if the gift were completed in April, the two-month lookback would allow us to use the 1.6 pct. rate from February.
Which is a spread of sixty basis points from the April rate and a hundred forty from the May rate in a number that is used as a multiplier in valuing the annuity. The leverage we could get by using the February rate was tens of thousands of dollars.[c]
the catch
However. And the taxpayer already knew this and accepted it.
It is widely believed among tax professionals, including your correspondent, that the income tax deduction would be limited, regardless of the current value of the unexpired annuity, to the taxpayer's "unrecovered investment" in the annuity contract at the time of the assignment.
That amount goes down every year, so the incentive to do this transaction is early. In the particular case, since this was a deferred annuity that had not yet commenced, the taxpayer had recovered no basis at all, but she had of course aged several years.
So a portion of the projected annuity payout over the expected return multiple[d] would be allocated to the recovery of the taxpayer's basis, and a portion would be allocated to long term gain. And those amounts, at least, would be deductible in full.
But everything above those amounts would eventually have been paid to the taxpayer as ordinary income. Does Code section 170(e)(1)(A) require a reduction here? Seems likely.[e]
But this is a matter for the taxpayer's legal and tax advisors. My role as appraiser (reference the blog post title) does not include opining on the amount of the deduction itself.
In some other case I might be brought in by one of the advisors, and I could help them frame an opinion. But that was not this case.
But if I say anything about this in the text of the appraisal, the taxpayer will in effect be pre-empted from taking a different reporting position. Not my role, as I openly explained to the taxpayer.
So the appraisal recites the present value of the unexpired annuity, measured over a slightly longer life expectancy than had been projected at the time the annuity contract had been signed, and reflecting the leverage obtained by electing the February 7520 rate.
And it says nothing about the likely limitation due to the reduction rule, because my opinion relates only to the value the issuing charity is actually receiving, not to whether some portion of that value might not be deductible.
notes
[a] See, e.g., Rev. Rul. 2009-13, 2009-1 C.B. 1029. Also, Estate of Katz, 309 F.2d 587 (1st Cir. 1962), aff'g T.C.Memo. 1961-270.
The idea that an existing gift annuity contract should be seen by folks in development as a capital asset that might itself be the subject of a gift is the premise of what has become my signature talk for roundtable breakfasts and regional conferences. I gave an early version of this talk at the national conference in Las Vegas in 2018, linked here.
[b] If she does not survive the term of years, any unrecovered investment will be an itemized deduction on her final 1040. Technically "miscellaneous" itemized, but not subject to the two pct. floor nor to the temporary suspension of miscellaneous itemized deductions through 2025.
[c] The 7520 rate had held at 1.6 pct. for three months after making a mostly steady climb over a full year from an historic low 0.4 pct., which had itself held for four months, from August through November 2020. Those days appear to be gone.
[d] As determined at the inception of the contract.
[e] The arguments I have seen against are unconvincing. We can get into that elsewhere if you like.
Tl;dr, the differences in the value of a gift annuity over time are entirely a function of the annuitant aging into slightly longer table life expectancies and to fluctuations in the 7520 rate. Or in the extreme case, the insolvency of the issuing charity.
There is no underlying investment whose performance we are measuring, analogous to the "inside buildup" in an insurance policy, cf. the revenue ruling cited in footnote [a].
In effect, the gift annuity is an unsecured promissory note arising from an installment sale.
Following up on an item I posted here last August. This is the second in what may turn out to be an intermittent series.
The other day I was engaged to write up a "qualified appraisal" on the assignment of a gift annuity to the issuing charity. A not at all uncommon transaction that should maybe be more common than it is.
This is a gift of a noncash capital asset,[a] subject to the 30 pct. limitation per section 170(b)(1)(B).
If the taxpayer acquired the annuity in exchange for appreciated property, her basis in that property would have been pro rated between the "gift" and "sale" components of the transaction. Over a term of years called the "expected return multiple," i.e., her table life expectancy at the time the annuity was set up, a portion of each payment represents a recovery of basis and a portion represents realization of gain, somewhat in the manner of an installment sale.
Yet another portion of each annuity payment is ordinary income. If the annuitant survives the "expected return multiple," she will have fully recovered her "investment" in the contract,[b] the basis and capital gain components, and the entire annuity payout going forward will be ordinary income.
Are you with me so far.
The present value of the unexpired annuity itself trends down as the annuitant ages, but it also fluctuates as the section 7520 rate moves up or down. In the particular case, just as the taxpayer was making the decision to assign the annuity to the issuing charity, the 7520 rate was rising rapidly.
The rate for April was already up to 2.2 pct., and we were looking at a solid 3.0 pct. coming up in May, the highest rate in three years. But if the gift were completed in April, the two-month lookback would allow us to use the 1.6 pct. rate from February.
Which is a spread of sixty basis points from the April rate and a hundred forty from the May rate in a number that is used as a multiplier in valuing the annuity. The leverage we could get by using the February rate was tens of thousands of dollars.[c]
the catch
However. And the taxpayer already knew this and accepted it.
It is widely believed among tax professionals, including your correspondent, that the income tax deduction would be limited, regardless of the current value of the unexpired annuity, to the taxpayer's "unrecovered investment" in the annuity contract at the time of the assignment.
That amount goes down every year, so the incentive to do this transaction is early. In the particular case, since this was a deferred annuity that had not yet commenced, the taxpayer had recovered no basis at all, but she had of course aged several years.
So a portion of the projected annuity payout over the expected return multiple[d] would be allocated to the recovery of the taxpayer's basis, and a portion would be allocated to long term gain. And those amounts, at least, would be deductible in full.
But everything above those amounts would eventually have been paid to the taxpayer as ordinary income. Does Code section 170(e)(1)(A) require a reduction here? Seems likely.[e]
But this is a matter for the taxpayer's legal and tax advisors. My role as appraiser (reference the blog post title) does not include opining on the amount of the deduction itself.
In some other case I might be brought in by one of the advisors, and I could help them frame an opinion. But that was not this case.
But if I say anything about this in the text of the appraisal, the taxpayer will in effect be pre-empted from taking a different reporting position. Not my role, as I openly explained to the taxpayer.
So the appraisal recites the present value of the unexpired annuity, measured over a slightly longer life expectancy than had been projected at the time the annuity contract had been signed, and reflecting the leverage obtained by electing the February 7520 rate.
And it says nothing about the likely limitation due to the reduction rule, because my opinion relates only to the value the issuing charity is actually receiving, not to whether some portion of that value might not be deductible.
notes
[a] See, e.g., Rev. Rul. 2009-13, 2009-1 C.B. 1029. Also, Estate of Katz, 309 F.2d 587 (1st Cir. 1962), aff'g T.C.Memo. 1961-270.
The idea that an existing gift annuity contract should be seen by folks in development as a capital asset that might itself be the subject of a gift is the premise of what has become my signature talk for roundtable breakfasts and regional conferences. I gave an early version of this talk at the national conference in Las Vegas in 2018, linked here.
[b] If she does not survive the term of years, any unrecovered investment will be an itemized deduction on her final 1040. Technically "miscellaneous" itemized, but not subject to the two pct. floor nor to the temporary suspension of miscellaneous itemized deductions through 2025.
[c] The 7520 rate had held at 1.6 pct. for three months after making a mostly steady climb over a full year from an historic low 0.4 pct., which had itself held for four months, from August through November 2020. Those days appear to be gone.
[d] As determined at the inception of the contract.
[e] The arguments I have seen against are unconvincing. We can get into that elsewhere if you like.
Tl;dr, the differences in the value of a gift annuity over time are entirely a function of the annuitant aging into slightly longer table life expectancies and to fluctuations in the 7520 rate. Or in the extreme case, the insolvency of the issuing charity.
There is no underlying investment whose performance we are measuring, analogous to the "inside buildup" in an insurance policy, cf. the revenue ruling cited in footnote [a].
In effect, the gift annuity is an unsecured promissory note arising from an installment sale.
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